Transfer Pricing: an interesting case of method adjustment used in the analysis

by Andrea Petracca, Giulia Sabelli

In its judgment No. 36275 of 13 December 2022, the Court of Cassation ruled in favour of the taxpayer in a Transfer Pricing case, in which the Tax Authority challenged the use of the "cost plus method" ("CPM"), instead of the "comparable uncontrolled price" ("CUP").

The case

In the case at issue, the Italian Tax Authority notified to a company an assessment notice for the recovery of a higher taxable income, claiming the improper application of transfer pricing principles to transactions with its direct subsidiaries in Austria, France, and Switzerland.

Specifically, the Tax Administration replaced the prices charged by the company in the above transactions with the higher prices resulting from the application of the CUP model. That is because, according to the authority, these would be the prices charged in a transaction between independent parties.

Nevertheless, several preliminary remarks on Transfer Pricing analysis methods should be made.

The CUP is the method that the OECD Guidelines identify as the most direct and preferable method used to determine the compatibility of conditions applied between affiliated entities with the arm's length principle, which involves comparing intra-group prices with prices charged in comparable transactions between independent entities conducted under similar circumstances.

However, in the event of differences in comparative transactions, the CUP may be applied only if at least one of these conditions is satisfied:

  • differences don’t affect the pricing process;
  • differences can be nullified with certain adjustments.

In the case at hand, in the company's view, the Cup should not have applied them because the lower prices charged on transactions compared to those charged with independent customers were due to ineliminable factors.

This is confirmed by the fact that an essential part of a TP analysis is the functional test by which the activities performed by each company in the group are analysed. In fact, the functional analysis carried out by the parent company, had established that the taxpayer's subsidiaries had performed functions and engaged risks that are not required in transactions with independent customers.

As a result, the taxpayer company opted to use the cost-plus method (CPM), which compares the margin between revenues and costs of transactions with subsidiaries and the margin of transactions with independent customers.

The company, victorious only in the first instance, therefore appealed in Cassation against the second instance judgment of the Bolzano Tax Commission rendered in favour of the Tax Office, on the following summarized grounds:

  • the company contested the failure to examine the factual circumstances which affected the validity of the CUP method used by the Tax Agency;
  • the company challenged the absolute deficiency of explanation on the reasons why the Appellate Court found irrelevant the various factual elements related to the diversity/specificity of the functions performed and risks assumed in the intercompany transactions.

The judgment

The Supreme Court of Cassation upheld the taxpayer's appeal, finding that the appealed judgment "does not explain in any way the reasons why the factual elements represented by the taxpayer company (...) have no impact for the purpose of identifying the normal value according to the comparable uncontrolled price method.”

The Court concludes by stating that "the general statement in the judgment under appeal also constitutes a violation of the OECD Guidelines, which permit the application of the price comparison method only in the presence of genuinely comparable transactions. And for these purposes, as seen above, the functions performed by the undertakings and the allocation of risks between the contractual parties play a decisive role”.

The analysed sentence is notable because it establishes the necessity of considering the specificities of the intercompany relationships in the context of a TP analysis; specificities that must also be considered by the Office when adjusting transfer prices and in selecting alternative methods to those used by the taxpayer.